VCs, Alpha Becoming Beta, and Cashout Deals

Venture capital funds have a lot more money than they did in the 1990's (pre-boom.) That could mean more money for a wider variety of investments. Or, it could mean more money chasing the same opportunities. It seems likely that, like any other investment strategy, good ideas get copied and great returns can't scale to large amounts of money under management.

Even if there are still a ton of great investments available, more money available means that entrepreneurs have somewhat more leverage (they may have two or three funds interested in them). This is combined with a secular trend that lowers the amount of money needed to build a IT startup. So VCs may be feeling a little bit of squeeze, although it appears angel investors may actually be taking the worst of it...

But, if we think about it from the VC's point of view, there are a few things he or she can do to prop up returns. The VC either needs more winners, bigger wins, or a bigger share in the winners. And I think that last option explains a recent trend towards founders (partially) cashing out during funding rounds. (I am not sure this is actually a trend or just a series of anecdotes. It seems more common now than during the boom.)

Suppose company X has 30% chance of being worth $1B in two years, and 70% chance of being worth $10m. They need to raise an additional $10m worth of funding to cover those two years. From a straight EV perspective, company X would be valued at around $307m. The fair investment value would be somewhat lower due to time value of money and risk, etc. So let's say the VCs put a $100m valuation on the company, just to keep the math simple.

Scenario A: The VC puts in $10m for a $110m post-money valuation. He gets 10/110 of the company, or about 9.1%. At exit, 70% of the time he gets $91m (net +$81m), while the other 30% his liquidation preference takes the $10m putting him even. Expected value = $56.7m.

An entrepreneur who owned 20% of the company pre-money owns about 18.2% afterward, so in the good case he picks up $182m and in the bad case he ends up with 0, expected value = $127.4m.

Scenario B: The VC talks the founders around into accepting a little bit more cash, $11m for a $111m post-money valuation. Her expected value at exit is now around $61.4m (the VC takes a $1m loss on the bad exit.) The founder's expectation decreases to $126.1m.

Scenario C: The VC offers to buy $1m of the founder's stock in addition to the $10m to the company, so now he owns 10% of the company. At exit, 70% of the time he nets $89m and the other 30% he loses $1m, so expectation goes up a notch to $62.0m. The founder now has EV $121.9m, but has reduced her risk substantially. This is *almost* as good an investment for the VC as scenario A (5.64x vs. 5.67x) and might be the best use for that next $1m of assets.

So, if there is more money chasing deals (giving the VC less leverage on valuation) and less money is needed (giving the VC a smaller piece of the pie), then giving the founders a partial exit looks like an efficient way of leveraging the additional cash. Traditional VCs can't really do 20x $5m deals instead of 10x $10m deals, although there are some funds that are trying the former approach--- the math above works even better for scenario C if you assume there is some cost per deal/company.